- A bank account overdraft happens when an individual’s bank account balance goes down to below zero, resulting in a negative balance. It usually happens when there are no more funds in the account in question, but an outstanding transaction is processed through the account, leading to the account holder incurring a debt.
- A debt is incurred because, with an overdraft, the bank effectively automatically lends the amount necessary to process the transaction to the account holder, an amount that needs to be returned, along with possible fees
- Though it seems helpful to the account holder, costs can spiral out of control if overdrafts are not handled promptly and properly.
Example
Consider the following scenario. Let’s say Santosh went to a retail outlet and purchased cosmetics amounting to Rs:50000 and wrote a check for the purchase. However, when the merchant deposited the check in the bank, Santosh’s account only contained Rs 15000, which means that he is Rs 35000 short of what is due for the check.
Two outcomes are possible – either the merchant’s bank will pay him the full amount, or they will let the check “bounce” to Santosh’s bank and stamp it with “NSF” (non-sufficient funds). In case the first outcome unfolds, Santosh will be charged for the Rs 35000 overdraft.
Types of Overdrafts Account
- Authorized bank overdraft
- With an authorized overdraft, the arrangement is made well in advance between the account holder and their bank.
- Both parties agree to a borrowing limit that can be used on all normal payment methods.
- The arrangement comes with a service fee that varies from bank to bank.
- Usually, the fee is charged daily, weekly, or monthly, plus interest, which can be as high as a 15% to 20% annual percentage rate.
- Considering the sometimes very high fees, an overdraft arrangement can be very expensive, especially if the borrowed amount is very small.
2. Unauthorized bank overdraft
- As the term implies, this means that the overdraft has not been agreed upon in advance and the account holder has spent more than his account’s remaining balance.
- Unauthorized overdrafts can also happen even if there has been a prior agreement, if the account holder has gone beyond the agreed overdraft amount.
- Unauthorized bank account overdrafts incur higher fees, which makes them more expensive.
Advantages of Bank Account Overdrafts
- Provides convenience
- Saves time and paper
- Enables on-time payments
- Prevents bouncing checks
- Perfect for mismatch of cash
